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alerting them to dangers so they can take corrective action. Investors, then,
have to know how to set up an instrument panel whose dials they can read.
This ability to read the panel means that investors establish their own in-
struments”ones appropriate to the venture, ones they are familiar with.
“We believe,” declared the late President Ronald Reagan, “that no
power of government is as formidable a force for good as the creativity and
entrepreneurial drive of the American people.” Angel investors in particular
share Reagan™s vision, one that elevated the entrepreneur. Likewise, instead
of overly focusing on onerous covenants in legal investment agreements,
most early-stage investors, once having made a decision to invest, choose
to trust management. So the absence of legal contract terms and provi-
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The Venture Investing Process


sions serves only to increase the importance of monitoring mechanisms to fill
the void.
Conversely, some investors aware of the need for monitoring, if not con-
trol, because of past investment losses, will have negotiated deal structures
mandating monitoring functions, for example, board of directors service, or
staging of investment based on management™s achieving predetermined mile-
stones. These terms are designed by investors to help reduce risk, and in-
crease investor control, and allow the investor to monitor, if not influence,
management decision making.
Instruments that entrepreneurs can expect investors to use to monitor
the venture™s performance fall into two categories: passive and active moni-
toring and evaluation methods. Hands-off monitoring involves periodic re-
view of financial performance information, for example, tracking monthly
or quarterly financial statements using a strict reporting schedule and re-
quirements. There would be daily or weekly contact with management
through in-person meetings or telephone conferences during which the par-
ties discuss performance against planned milestones. Investors will also
maintain vigilance related to investment terms and conditions negotiated
earlier and structured into investment agreements.
Investors will track how management is using capital invested, and the
rate at which funds are being “burned.” Investors will try to detect prob-
lems by scanning costs, sales, earnings, profits, contract close rates, orders,
product development schedules, hiring, conformance to budget, and so on.
Such monitoring could lead investors to take action or suggest plan or strat-
egy revisions.
Individually and collectively, these monitoring devices amount to being
able to help when help is needed, instead of waiting past the time when ad-
versity can be reversed.
Perhaps the best example of passive involvement is participation by in-
vestors in the board of directors or advisory board if concerns arise about
D&O exposure. The primary function of early-stage company boards is to
monitor and evaluate the performance of management and suggest actions
necessary to correct situations for the good of the company and its owners.
Involvement by the board is a monitoring strategy that allows investors
to exercise some degree of influence on decisions and pass along successful
managerial and extensive experience and knowledge to less experienced en-
trepreneurs. Boards permit investors a nonexecutive role to function as a
sounding board as well as to add value.
Active monitoring and advisory functions also allow investors to add
value, but are characterized by a more hands-on approach to provide follow-
on support and to influence management decision making. Rarely are entre-
preneurial management teams complete, with all the necessary functional
240 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


skills present in the team. Based on our research at ICR, 25 percent of the
time, angel investors step in personally to fill those gaps lacking in the
management team. More specifically, in our study of 60 early-stage ICR in-
vestors, investors reported that they were qualified and willing to provide
management assistance in the following areas: 48 percent in marketing and
sales; 28 percent in production; 13 percent in R&D; 23 percent in personnel;
63 percent in general management; 15 percent in financial planning; and 5
percent in engineering.
As one investor put it, “What also gets my attention is . . . an action plan
from someone who demonstrates that over the next 90 to 180 days, from the
time the company receives the money, he or she can enumerate what exactly
has to be done to make this business go. The more specific those kinds of
milestones are, the more comfortable I am in knowing that I can measure
progress after I™ve made the investment and calibrate how I should react”
that is, whether I™ve made a mistake, or whether I should invest additional
capital if I™m asked. This is a very good way both to monitor the investment
and to assess how management is doing and what you can do to help them.”


HARVESTING RETURNS: REALISTIC EXIT STRATEGIES
While venture and angel capital had been described as “patient money,” we
have never, after 15 years of experience of working with early-stage in-
vestors, heard an investor declare, “I wish I had spent less time thinking
about exit and liquidity before I invested.” An exit route is the means by
which an investor leaves an investment and through which he or she is able
to realize returns.
Alternative exit strategies include IPO, sale of investor™s stock back to
the founders, leveraged buyout and recapitalization of the company, sale of
the company, merger or acquisition with a publicly traded company in ex-
change for liquid or tradable stock, or transfer of stock to other investors.
Not all companies are IPO candidates. And given the sluggish nature of
the IPO market, entrepreneurs would be better served to not overemphasize
IPO as their primary strategy for exit, particularly to angel investors. With
22,000,000 private companies in the United States and just 30,000 public
companies, fewer than one tenth of one percent are traded on the major
stock exchanges. The IPO as a liquidity vehicle for venture-backed compa-
nies”though beginning in 2004 to show signs of life”has dried up, and is a
mere shadow of the $69 billion, 546 IPOs investors funded in 1999. This
fact, combined with rigorous listing requirements, high fixed costs of the
IPO, complex regulatory requirements (e.g., Sarbanes-Oxley), and the re-
quirements that the company has grown large enough to float its stock on a
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The Venture Investing Process


major exchange, all contribute to conspire against the daunting prospect of
exiting by an IPO.
Today, thousands of companies are turning to merger, acquisition, and
corporate buyout to provide exit and liquidity. Merger can involve the in-
vestee company being combined with a larger corporation or being acquired
by the same and receiving cash and marketable securities for the sale. When
strong strategic benefits are present, trade sales or sales of one company to
another are possible transactions, for instance, synergistic products or tech-
nology. Buy back is an exit route in which the investor cashes out by selling
securities back to the founders, typically when the terms of the sale are tied
to operating performance and cash flow of the company. The leveraged buy-
out is a buy back using debt. The prearranged take out can be an exit for pri-
vate investors in marginally performing companies. This method has the
investor tendering to the company a percentage of the company shares,
shares held at a price that relates to a predetermined multiple of earnings or
cash flow. The entrepreneurs can have a call that would be exercised at some
multiple value after they have successfully achieved a pre-agreed on level of
earnings or cash flows. Another liquidity route is the secondary sale, or the
sale of some or all shares to a third party.
Returns to investors take the form of long-term capital gains realized
after an extended period during which an investment provides little or no liq-
uidity or marketability. The method and timing of liquidation expectations
are important variables in a venture capital investment decision. Shared exit
expectations are particularly critical for ventures with limited prospects for a
public offering or acquisition by a larger firm within the typical five- to
ten-year exit horizons of venture investors. It is important to make clear
early the investor™s interest in achieving liquidity at the highest price within a
specified time frame, for example, seven years. This interest in achieving liq-
uidity needs to be more than a verbal agreement; terms should be clearly
specified in writing and on solid legal ground. In developing a strong set of
terms and conditions during negotiations, do not underestimate the impor-
tance of auditing, monitoring, and engaging good legal counsel.
Many angels and high-net-worth, early-stage investors, it is true, are mo-
tivated by nonfinancial returns. Such altruistic driving forces include creat-
ing jobs in regions of high unemployment, investing in socially useful
technology in medicine or nonpolluting energy, financing ventures created by
women and minority entrepreneurs, and the personal sense of accomplish-
ment that building a sustainable company engenders. However, another,
more primal, drive operates in today™s economy, a reason why institutions
entrust $200 million to $400 million with a small handful of venture capi-
talist money manager-investors, a reason they invest $7 million to $10 mil-
lion per deal into 30 to 40 companies within three to five years. The reason
242 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


is simple: 15 to 20 of those company investments, particularly earlier-stage,
will provide five times returns in seven years and, at exit, the investors plan
to own 25 percent of the company. Since in today™s market, exit is more
likely to be merger, acquisition, or sale, the current range of transaction
prices of $100 million to $300 million starts to give the reader a sense of the
capital appreciation possible, and why this type of investing remains a part
of institutional portfolios.
Angels and other investors will want to clarify exit routes early in the
discussions with entrepreneurs. While they will focus on helping the com-
pany succeed, they want to be able to get their investment back and earn a
return for the loss of use of capital. So entrepreneurs need to identify alter-
native, plausible exit routes early in the negotiations.
What, then, are reasonable early-stage investor™s expectations for finan-
cial returns?
Invariably the questions will arise for the investor: “How much can I
make?” and “How much can I lose?” Remember, for investors to realize at-
tractive rates of return, they may be more interested in avoiding a bad in-
vestment than in hitting a home run, the former often carrying a bigger
wallop than the latter. Investors attempt to avoid the bad ones by using the
venture investment process we described in this chapter. Investors also pos-
sess expectations about rates of return that they and their colleagues believe
to be reasonable and realistic. Returns on investment are the result of vari-
ous combinations of good judgment, skill, and luck (although we should re-
member that the harder we work, the luckier we seem to get).
Private equity five-year returns for 1,600 U.S. venture capital and pri-
vate equity funds range from 54 percent for early-stage and seed-stage
venture capital funds to 7.6 percent for later-stage venture capital funds.
The 20-year private equity performance of early-stage/seed venture capital
funds remains steady since the early 1990s at 19 to 20 percent. Important
to comprehending ROI for venture investors is the time that investors hold
the investment before they exit to harvest returns. For example, a three-
times return on investment earned in three years yields a 44 percent ROI,
whereas a three-times return on investment in five years drops the yield to 38
percent ROI.
Exhibit 11.1 shows how one venture capital fund fared in its investments.
By contrast, consider the targeted rates of return in Exhibit 11.2. While
investors may target aggressive annualized multiples, actual results often fall
short of the investment plan objectives.
In ICR™s 1999“2000 study of 1,200 angel investors queried on internal
rates of return, we found that over a mean hold term of eight years, 39 per-
cent reported all or partial loss of investment; 19 percent reported break even
or nominal returns; 30 percent reported cumulative returns of 50 percent or
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The Venture Investing Process


EXHIBIT 11.1 Professional Venture Capital Returns* on Investment

Total loss 11.5%
Partial loss 23%
Break even 30%
2“5 times investment 19.8%
5“10 times investment 8.9%
10 or more times investment 6.8%

*Cash on cash + capital gains.


EXHIBIT 11.2 Annualized Targeted Rates of Return

Description Internal Rate of Return*
Seed/start-up 60%“100%
Development+ 50%“60%
Management team revenues/expansion 40%“50%
Profitable/cash poor 30%“40%
Rapid growth 25%“35%
Bridge to cash out 20%+

*Before applying subjective factors.



more per year; and 12 percent reported returns exceeding 100 percent. These
returns were all cash-on-cash, plus capital gains. Most investors interviewed
for our study stated that they aimed for a minimum of 30 percent internal
rate of return for investments in start-ups, establishing reasonable return ex-
pectations. Angels are also acutely aware of entrepreneurs™ tendency to un-
derestimate the time to liquidity, which holds significant implications as we
have presented for rate of return.
12
CHAPTER

Preparing for Due Diligence


INTRODUCTION

Over the years, ICR has collected questions asked of entrepreneurial clients
who have gone through due diligence with investors accessed through the
firm. We have organized the many questions compiled in this chapter
through their research using a framework developed by venture capitalist
Justin Camp. Entrepreneurs can use this framework and the questions com-
piled by ICR and us to help prepare themselves for the inevitable due dili-
gence audit.
The early-stage venture capital due diligence framework presented here
was used in two of the Wharton School graduate-level MBA courses. For a
complete presentation of this research, we refer the reader to another Wiley
Finance book by Mr. Camp titled Venture Capital Due Diligence. A com-
plete citation can be found in the Suggested Reading List (Appendix C).
An investor relies on solid judgment in evaluating a deal on its own mer-
its. To do so mandates a comprehensive investigation and analysis. Due dili-
gence is no more than the caution any prudent person would exercise with
his or her own money. Nothing takes the place of a full venture audit, an in-
depth investigation spanning prescreening, assessment of management, ex-
amination of the business opportunity, scrutinizing intangible aspects of the
situation, and diagnosis of the legal and financial aspects of the deal. The in-
vestor is judging the workability of the early-stage investment. To do so en-
tails interviews and meetings, document reviews, and extensive research and
analysis. Experts will be used to facilitate background checks and provide
technical expertise beyond that of the investor. Especially when the investor
is considering a venture outside of his or her experience, practicing due dili-
gence and using outside advisers will take on even more importance.
In this chapter we have organized the essential queries that entrepre-
neurs will need to be prepared to answer. We also provide suggestions on
documentation the entrepreneur must have on hand during the investigation.



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